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August 18, 2015

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Fed Watch: Some Thoughts On Productivity And The Fed
Posted: 18 Aug 2015 12:15 AM PDT

Tim Duy:
Some Thoughts On Productivity And The Fed, by Tim Duy: Will flagging productivity growth trigger a hawkish response from the Fed? That is a question I have been asking myself since Federal Reserve Chair Janet Yellen discounted the cyclical influences of low wage growth in her July 10 speech:
The most important factor determining continued advances in living standards is productivity growth, defined as the rate of increase in how much a worker can produce in an hour of work. Over time, sustained increases in productivity are necessary to support rising household incomes…Here the recent data have been disappointing. The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
Goldman Sachs economists led by Jan Hatzius hypothesize that productivity growth is low only because growth is mis-measured, undercounting the value of free or improved software and digital content made possible by information technology (although see Greg Ip's opposing view). It seems that Yellen is leaning in the direction of taking the productivity numbers at face value and seeing low wage growth as consistent with the view that the productivity slowdown is real.
Indeed, the productivity trends may be even grimmer than 1-1/4 percent that Yellen cited in her speech. Consider for example two measures of underlying productivity growth trends, a moving average measure and the result from a simple unobserved components model:
The downtrend since 2000 is more easily discerned by focusing only on the trends:
The unobserved component approach suggests that productivity growth decelerated to an annualized pace of just 0.82 percent by the second quarter of this year. That is interesting because it must be somewhat similar to the Fed staff estimates. The accidentally released Fed staff estimates of potential GDP growth range from roughly 1.6 to 1.8 percent through 2020. That is exactly what you might expect with productivity growth of around 0.8 percent and labor force growth in the between 0.8 to 1.0 percent (roughly the recent range). It seems the Fed staff have adopted the pessimistic view of the productivity numbers. It is not about measurement error.
What are the implications for policy? Yellen might think back to the 1990's, when a surprise rise in productivity growth temporarily lowered the natural rate of unemployment. Slow wage adjustment meant higher than expected productivity growth had a disinflationary impact on the economy, allowing for then Federal Reserve Chairman Alan Greenspan to hold interest rates relatively low. Yellen might reverse that logic now and think that the arguments for tighter policy are stronger. Hence another reason why low wage growth is not an impediment to raising rates.
Any increase in the natural rate of unemployment, however, would be temporary. After wage growth adjusts, we would expect the equilibrium real interest rate to fall in response to lower productivity growth. Lower productivity growth reduces the expected return on capital, thus requiring lower interest rates to maintain neutral policy.
The trick then is determining whether we are still in the short-run or already in the long-run. It may be that wages have already adjusted. Real wage growth was fairly high during the recession and it's aftermath:
Real wage growth – using core-PCE as the deflator – was high as wages adjusted during the recession, but then remained high even when unemployment was above six percent. Now real wages are running low. Could it be that the wage adjustment to lower productivity growth occurred during the recession? If so, the Fed would be in error to believe that now is the time to tighten policy in response to low productivity growth. In effect, the zero bound unintentionally did that job for them. Not only did wage growth adjust, but any potential inflationary impacts were overwhelmed by the disinflationary impacts of the recession.
The bond market, with ten-year Treasury yields hovering between 2 and 2.5 percent, appears to be fiercely discounting the lower-for-longer story consistent with low productivity growth. Furthermore, low TIPS-based inflation expectations and a modest expected path for short rates also suggest little need for the Fed to tighten policy to avoid a 1970's style inflation. The FOMC, however, has a more hawkish view, anticipating a more aggressive policy over the next few years. The Fed staff split the difference in their forecasts. The direction the FOMC ultimately takes could be the difference in an expansion that last four more years or only two.
Bottom Line: Fed policy increasingly reflects the view that the productivity growth slowdown is real. We see it in falling estimates of potential GDP growth, falling expectations for the terminal federal funds rate, and now we see it as a reason to anticipate low wage growth. The first and third reactions seem to have had a hawkish impact on policy - not only is low wage growth not an impediment to raising rates, but San Francisco Federal Reserve President John Williams argued the Fed needs to engineer a substantial slowdown in growth next year. But the FOMC has yet to act on that relative hawkishness; to date they have moved in the direction of market participants. Indeed, while I suspect the odds favor a September hike, we don't even know they will raise rates this year at all! The question is whether they would be quick to act on that hawkishness in the face of any unexpectedly high inflation or wage growth numbers. I am thinking low-productivity growth coupled with memories of the 1970s may prime FOMC members in that direction.

Links for 08-18-15
Posted: 18 Aug 2015 12:06 AM PDT

Stiglitz: Towards a General Theory of Deep Downturns
Posted: 17 Aug 2015 11:34 AM PDT

This is the abstract, introduction, and final section of a recent paper by Joe Stiglitz on theoretical models of deep depressions (as he notes, it's "an extension of the Presidential Address to the International Economic Association"):
Towards a General Theory of Deep Downturns, by Joseph E. Stiglitz, NBER Working Paper No. 21444, August 2015: Abstract This paper, an extension of the Presidential Address to the International Economic Association, evaluates alternative strands of macro-economics in terms of the three basic questions posed by deep downturns: What is the source of large perturbations? How can we explain the magnitude of volatility? How do we explain persistence? The paper argues that while real business cycles and New Keynesian theories with nominal rigidities may help explain certain historical episodes, alternative strands of New Keynesian economics focusing on financial market imperfections, credit, and real rigidities provides a more convincing interpretation of deep downturns, such as the Great Depression and the Great Recession, giving a more plausible explanation of the origins of downturns, their depth and duration. Since excessive credit expansions have preceded many deep downturns, particularly important is an understanding of finance, the credit creation process and banking, which in a modern economy are markedly different from the way envisioned in more traditional models.
Introduction The world has been plagued by episodic deep downturns. The crisis that began in 2008 in the United States was the most recent, the deepest and longest in three quarters of a century. It came in spite of alleged "better" knowledge of how our economic system works, and belief among many that we had put economic fluctuations behind us. Our economic leaders touted the achievement of the Great Moderation.[2] As it turned out, belief in those models actually contributed to the crisis. It was the assumption that markets were efficient and self-regulating and that economic actors had the ability and incentives to manage their own risks that had led to the belief that self-regulation was all that was required to ensure that the financial system worked well , an d that there was no need to worry about a bubble . The idea that the economy could, through diversification, effectively eliminate risk contributed to complacency — even after it was evident that there had been a bubble. Indeed, even after the bubble broke, Bernanke could boast that the risks were contained.[3] These beliefs were supported by (pre-crisis) DSGE models — models which may have done well in more normal times, but had little to say about crises. Of course, almost any "decent" model would do reasonably well in normal times. And it mattered little if, in normal times , one model did a slightly better job in predicting next quarter's growth. What matters is predicting — and preventing — crises, episodes in which there is an enormous loss in well-being. These models did not see the crisis coming, and they had given confidence to our policy makers that, so long as inflation was contained — and monetary authorities boasted that they had done this — the economy would perform well. At best, they can be thought of as (borrowing the term from Guzman (2014) "models of the Great Moderation," predicting "well" so long as nothing unusual happens. More generally, the DSGE models have done a poor job explaining the actual frequency of crises.[4]
Of course, deep downturns have marked capitalist economies since the beginning. It took enormous hubris to believe that the economic forces which had given rise to crises in the past were either not present, or had been tamed, through sound monetary and fiscal policy.[5] It took even greater hubris given that in many countries conservatives had succeeded in dismantling the regulatory regimes and automatic stabilizers that had helped prevent crises since the Great Depression. It is noteworthy that my teacher, Charles Kindleberger, in his great study of the booms and panics that afflicted market economies over the past several hundred years had noted similar hubris exhibited in earlier crises. (Kindleberger, 1978)
Those who attempted to defend the failed economic models and the policies which were derived from them suggested that no model could (or should) predict well a "once in a hundred year flood." But it was not just a hundred year flood — crises have become common . It was not just something that had happened to the economy. The crisis was man-made — created by the economic system. Clearly, something is wrong with the models.
Studying crises is important, not just to prevent these calamities and to understand how to respond to them — though I do believe that the same inadequate models that failed to predict the crisis also failed in providing adequate responses. (Although those in the US Administration boast about having prevented another Great Depression, I believe the downturn was certainly far longer, and probably far deeper, than it need to have been.) I also believe understanding the dynamics of crises can provide us insight into the behavior of our economic system in less extreme times.
This lecture consists of three parts. In the first, I will outline the three basic questions posed by deep downturns. In the second, I will sketch the three alternative approaches that have competed with each other over the past three decades, suggesting that one is a far better basis for future research than the other two. The final section will center on one aspect of that third approach that I believe is crucial — credit. I focus on the capitalist economy as a credit economy , and how viewing it in this way changes our understanding of the financial system and monetary policy. ...
He concludes with:
IV. The crisis in economics The 2008 crisis was not only a crisis in the economy, but it was also a crisis for economics — or at least that should have been the case. As we have noted, the standard models didn't do very well. The criticism is not just that the models did not anticipate or predict the crisis (even shortly before it occurred); they did not contemplate the possibility of a crisis, or at least a crisis of this sort. Because markets were supposed to be efficient, there weren't supposed to be bubbles. The shocks to the economy were supposed to be exogenous: this one was created by the market itself. Thus, the standard model said the crisis couldn't or wouldn't happen ; and the standard model had no insights into what generated it.
Not surprisingly, as we again have noted, the standard models provided inadequate guidance on how to respond. Even after the bubble broke, it was argued that diversification of risk meant that the macroeconomic consequences would be limited. The standard theory also has had little to say about why the downturn has been so prolonged: Years after the onset of the crisis, large parts of the world are operating well below their potential. In some countries and in some dimension, the downturn is as bad or worse than the Great Depression. Moreover, there is a risk of significant hysteresis effects from protracted unemployment, especially of youth.
The Real Business Cycle and New Keynesian Theories got off to a bad start. They originated out of work undertaken in the 1970s attempting to reconcile the two seemingly distant branches of economics, macro-economics, centering on explaining the major market failure of unemployment, and microeconomics, the center piece of which was the Fundamental Theorems of Welfare Economics, demonstrating the efficiency of markets.[66] Real Business Cycle Theory (and its predecessor, New Classical Economics) took one route: using the assumptions of standard micro-economics to construct an analysis of the aggregative behavior of the economy. In doing so, they left Hamlet out of the play: almost by assumption unemployment and other market failures didn't exist. The timing of their work couldn't have been worse: for it was just around the same time that economists developed alternative micro-theories, based on asymmetric information, game theory, and behavioral economics, which provided better explanations of a wide range of micro-behavior than did the traditional theory on which the "new macro - economics" was being constructed. At the same time, Sonnenschein (1972) and Mantel (1974) showed that the standard theory provided essentially no structure for macro- economics — essentially any demand or supply function could have been generated by a set of diverse rational consumers. It was the unrealistic assumption of the representative agent that gave theoretical structure to the macro-economic models that were being developed. (As we noted, New Keynesian DSGE models were but a simple variant of these Real Business Cycles, assuming nominal wage and price rigidities — with explanations, we have suggested, that were hardly persuasive.)
There are alternative models to both Real Business Cycles and the New Keynesian DSGE models that provide better insights into the functioning of the macroeconomy, and are more consistent with micro- behavior, with new developments of micro-economics, with what has happened in this and other deep downturns . While these new models differ from the older ones in a multitude of ways, at the center of these models is a wide variety of financial market imperfections and a deep analysis of the process of credit creation. These models provide alternative (and I believe better) insights into what kinds of macroeconomic policies would restore the economy to prosperity and maintain macro-stability.
This lecture has attempted to sketch some elements of these alternative approaches. There is a rich research agenda ahead.

Greenspan: Shelve Dodd-Frank
Posted: 17 Aug 2015 10:33 AM PDT

We should listen to Alan Greenspan on bank regulation, especially regulation of the shadow banking sector. After all, he was the one who argued we didn't need to worry about financial markets because the market would force them to self-regulate.
We all know how that turned out, including Greenspan's famous mea culpa on this issue. Greenspan says, as though we should listen, that Dodd-Frank financial reform needs to be reversed:
Higher reserves will secure the financial system with less pain, by Alan Greenspan, Commentary, Financial Times: ... What the 2008 crisis exposed was a fragile underpinning of a highly leveraged financial system. Had bank capital been adequate and fraud statutes been more vigorously enforced, the crisis would very likely have been a financial episode of only passing consequence.
If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. ...
Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks' loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility. ...
Actually, I agree on higher capital requirements, but we depart when he asserts that is all that is needed. In any case, had he been willing to push for something like this when he had control of the policy levers instead of steadfastly standing against it with a 'markets are always right' argument, maybe things turn out better.
Note: On his assertion about the recent decline in bond market liquidity, the NY Fed says:
Overall, our evidence is fairly favorable about the current state of Treasury market liquidity. Direct measures such as the bid-ask spread point toward liquidity that is quite good by recent historical standards. Other measures such as quote depth and price impact imply some recent deterioration in liquidity, albeit from unusually liquid conditions. The evidence suggests that market participants' liquidity concerns are not emanating from average levels of liquidity in the benchmark Treasury notes.

If average liquidity is generally good by historical standards, then why all the liquidity concerns? ...
I'll take a shot at answering that. Could it be a means to attack Dodd-Frank, and regulation more generally?
Two other observers, Cecchetti & Schoenholtz, also look at bond market liquidity:
...when knowledgeable people express concerns that regulatory changes are causing bond markets to malfunction (see, for example, here), it leads us to ask some tough questions. Are these markets somehow impaired? Is enhanced financial regulation to blame? Is this creating risks to the financial system as a whole?
To anticipate our conclusion, while bond markets are clearly evolving, we do not see reasons for immediate concern about the financial system as a whole. In fact, our expectation is that the capital and liquidity requirements that have made financial intermediaries more resilient to economic downturns and to interest rate spikes, also have improved their ability to stabilize bond markets. ...
Put another way, better regulation has removed the public subsidy to trading activity that banks and others were able to capture prior to the crisis...

Paul Krugman: Republicans Against Retirement
Posted: 17 Aug 2015 09:33 AM PDT

Why do Republicans want to get rid of Social Security?:
Republicans Against Retirement, by Paul Krugman, Commentary, NY Times: Something strange is happening in the Republican primary — something strange, that is, besides the Trump phenomenon. For some reason, just about all the leading candidates other than The Donald have taken a deeply unpopular position, a known political loser, on a major domestic policy issue. And it's interesting to ask why.
The issue in question is the future of Social Security... The retirement program is, of course, both extremely popular and a long-term target of conservatives, who want to kill it precisely because its popularity helps legitimize government action in general. ...
What's puzzling about the renewed Republican assault on Social Security is that it looks like bad politics as well as bad policy. Americans love Social Security, so why aren't the candidates at least pretending to share that sentiment?
The answer, I'd suggest, is that it's all about the big money.
Wealthy individuals have long played a disproportionate role in politics, but we've never seen anything like what's happening now: domination of campaign finance, especially on the Republican side, by a tiny group of immensely wealthy donors. Indeed, more than half the funds raised by Republican candidates through June came from just 130 families.
And while most Americans love Social Security, the wealthy don't. ... By a very wide margin, ordinary Americans want to see Social Security expanded. But by an even wider margin, Americans in the top 1 percent want to see it cut. And guess whose preferences are prevailing among Republican candidates.
You often see political analyses pointing out, rightly, that voting in actual primaries is preceded by an "invisible primary" in which candidates compete for the support of crucial elites. But who are these elites? In the past, it might have been members of the political establishment and other opinion leaders. But what the new attack on Social Security tells us is that the rules have changed. Nowadays, at least on the Republican side, the invisible primary has been reduced to a stark competition for the affections and, of course, the money of a few dozen plutocrats.
What this means, in turn, is that the eventual Republican nominee — assuming that it's not Mr. Trump —will be committed not just to a renewed attack on Social Security but to a broader plutocratic agenda. Whatever the rhetoric, the GOP is on track to nominate someone who has won over the big money by promising government by the 1 percent, for the 1 percent.

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